He was going to talk about this new book, A Fistful of Rice. It’s unfortunate that we won’t get to pick his brain regarding the debate generated by SKS’ recent IPO, and about the developing situation in Andhra Pradesh (AP).

If we may be permitted a whimsical moment, the Indian microfinance story offers an irresistible parallel to a familiar Bollywood plot: in the Indian microfinance potboiler, the SHG model is the elder brother in an Indian joint family while the MFIs play the part of an aggressive younger brother. The elder brother struggles to uphold tradition and retain his leadership position, while the maverick younger brother tries to break free (using new financial and technology tools), often overenthusiastically, and sometimes recklessly, in pursuit of the same goals. This script bears many similarities to a classic Bollywood family drama. Unfortunately, the conflict between the two brothers often leaves the family destitute. As the AP microfinance drama plays out in the national media and the world watches, it is mainly the poor, forced into choices not of their making, who will suffer.

This paper strengthens the uneasy feeling many were having – that the regulations are more good politics than good policy. Barring door-to-door servicing – really?

An Indian Express article, Andhra’s small-debt trap, that reports on the reality faced by micro-loan borrowers in a village in AP. Quite important to keep the caveats on media reports mentioned in the Intellicap White Paper in mind when reading this. Some of the anecdotes mentioned in the article are quite disturbing – fearful female borrowers assembling outside their houses at 7 a.m. sharp for the loan recovery agents to show up and having to pay late fees if they were even 5 mins late, 147 of the 150 households having multiple loans, and the men stopping going to work as farm laborers on getting loans instead of redirecting income towards investments.

In my last post, we saw how SKS’ write-offs levels went up from 0.29% in FY2008 to 0.60% in FY2009, and then up again to 0.86% in FY2010, and that PAR numbers followed a similar trend. Today, we’re going to look into this in more detail, and then ask why this might be an issue for SKS.

Tracking the increase

Before we go any further, let’s cross-check the numbers we got from MixMarket. Their numbers are generally very good, and allowing for reporting period disparities, differences in interpretation of similar terms, or differences in how something is bucketed, there is broad agreement in most cases with the numbers one gets from MFIs.

This is no different for SKS, which notes the following for it’s write-off figures in its Annual Report for 2009-2010:

And let me take this opportunity to say again why I am really happy about getting my hands on the Red Herring document – SKS has gone out of the way to provide an abundance of information, and it’s all very informative. There are two primary reasons that account for this, albeit partly:

Under their provisioning policy, they used to write off 50% of the loans overdue between 25 to 50 weeks (or 6 to 12 months, roughly) in FY2008. In FY2009, they wrote off 100%, i.e. the entire amount. Makes sense that this increased write-off, since this change doubled the number of loans they had to bump off the books for that category of loans, all other things remaining the same.

The portfolio grew during this period, to the tune of 81.5%. Again, makes sense that this increased write-offs – if you give out more loans, proportionately more loans will also have to be written-off, all other things remaining the same.

Here’s what’s interesting – once you normalize for these changes, (essentially deflating the 2,205.8% number by 100% and then by 81.5% again to account for the explanations) the write-offs still go up by approximately 600%… ! Gonna have to say it again – umm… what!?

Something is pushing up SKS’s bad loan count, and pushing it beyond what seems to be the average for Indian MFIs. As we saw in the previous post, the average write-off for the market was 0.52% in 2009; SKS’ figure was 0.73% for the corresponding period.

SKS needs to identify the drivers behind bad loans. I could hazard a couple of guesses:

Quality of staff – any any given point, three-quarters of SKS’ staff has been around for less than year. This is partly because of phenomenal growth leading to continuous hirings, and partly because of high staff turnover.

Credit policy – particularly those related to due diligence on loan disbursal and procedures for loan recovery

Resource focus on growth, as opposed to consolidation

Without looking at more detailed numbers or talking to SKS staff though, we’d be hard pressed to know which of these, if any, are key drivers of deteriorating portfolio quality.

Additional Mitigating Factors

Irrespective of the underlying drivers, there are two effects to keep in mind that make deteriorating portfolio quality a particularly pernicious issue for MFIs enjoying rapid growth:

Lag Effect: Loan vintages (i.e. loans given out during the same period – say a month) do not display full delinquency levels until a few months after disbursement. Given that most SKS loans have a 50-week term, a short 3 month catch-up period would mean that ¾ of the portfolio are displaying full delinquency levels, while a 6 month one would imply that only ½ of them were doing so – assuming 0% portfolio growth. This also means that if, for some reason, the overall portfolio quality deteriorates, it will not manifest itself fully for a good couple of months.

Dilution Effect: Of course, SKS’ portfolio is not growing at 0%. It grew 99% between FY2009 and FY2010, and according to the 2009-2010 Annual Report, has a CAGR of 150% over the last 4 years. Consider what this means for the lag effect. The earlier vintages that are now displaying full delinquency levels are essentially watered down, and the low or non-existent delinquency levels of newer vintages have a higher per-rupee weight. How much watering down happens is dependent on the vintage disbursement amounts, but in general, the dilution effect depresses the delinquency levels further.

Why is this an issue? Well, SKS cannot continue to grow at a CAGR of 150% for too many more years. The Indian MFI market is getting increasingly saturated, and the industry as a whole will need to slow down. As growth slows, the delinquency and write-off levels will catch up. If SKS does not anticipate this catch-up and prepare accordingly, investor confidence will take a blow, along with portfolio quality.

Vintage-level Analysis Has Some Answers

One can get a sense of what will happen in the future by literally seeing how loans in SKS’ portfolio age. Loans given out during the same period, usually a month, are said to be in the same vintage. I have not found any public information on SKS vintages, let alone their delinquency profiles. It’s generally not very helpful to guesstimate on this because such profiles can vary greatly between MFIs with similar top-level PAR and write-off numbers, and can differ substantially for different products even within the same MFI, so I’m not going to dive into a modeling exercise.

It’s not too difficult to figure out the lag and dilution effect though, if one has access to granular portfolio data. SKS would have to take each vintage, figure out its delinquency profile, derive historic trends by superposition, and account for differences based on product characteristics, branch office location or any other salient factors. It can then combine projected performance of existing vintages with internal growth targets, and see where the PAR and write-off numbers end up at.

Sure, the past is not necessarily the best predictor of the future, but given the purported out-of-the-box nature of SKS products in particular and microfinance products in general, and the short loan lifecycles that reveal profile changes relatively quickly, this should be a pretty useful exercise.

This is the first of a series of posts that will take a look at the numbers behind MFI operations. I find it to be quite an instructive exercise to wade through MFI data in the rare instances where they are available in any level of detail beyond mere institution-level aggregation, as presented in annual reports and the like.

We’ll first look at delinquencies and write-offs, and use the Indian MFI SKS as a case study of sorts. This is partly because the Red Herring released prior to its IPO provides a wealth of information that allows for more meaningful and in-depth analysis, and in general, affords a rare look at the inner workings of an institution enjoying prodigious growth while carving out a place in a rapidly evolving market. SKS is also the largest MFI in India, followed by Spandana and SHARE, and according to 2009 MixMarket data, serves about a fifth of the Indian MFI market. What we might glean from this is therefore relevant to a large chunk of the Indian microfinance market too.

PAR and Write-off as Measures of Delinquency

Well-run MFIs fastidiously maintain high portfolio quality. Many MFIs have primarily lent to women, who traditionally have excellent repayment rates. Many adhere to the Grameen group-lending model because they rely on peer support and pressure to enforce regular repayment habits. Very low delinquency and default rates have made this sector a favourite for investors, domestic and international.

Portfolio-at-Risk (PAR) is one of the standards of measuring delinquency for microfinance loan portfolios. It is defined as the total outstanding principal balance of loans with any amount of arrears due. Thus, if a $100 loan still has $45 in outstanding principal, and the $2 of that was due last week is not paid up, the PAR amount is noted as $45. In a way, PAR is the most conservative measure of how much loss the portfolio would suffer, since this is the maximum value that the MFI would lose from this loan if nothing more was ever paid back.

PAR is usually associated with a number of days count, where PAR30 would mean the total outstanding principal balance with any amount of arrears due for over 30 days, PAR60 for 60 days, and so on. Many MFIs will typically provision against 100% of the PAR120 amount, thus assuming that none of it can be recovered.

Once a loan is written off, it is no longer on the books of the MFI.

SKS Delinquency Profile

The unweighted averages for PAR30 and write-offs were 1.84% and 0.52% respectively for Indian MFIs with more than USD 10m in gross loan portfolio. When one considers the weighted averages, the corresponding figures are 0.59% and 0.54%. (The weight applied is principal outstanding.) We are interested in looking at the weighted average, by the way, because it gives us a sense of how every dollar (or rupee) in the portfolio is doing, on average, as opposed to every loan, which would be the case for the unweighted measure. Comparing the two PAR30s tells us that larger portfolios have much lower PAR amounts on average – this is quite interesting, and we’ll come back to why a little later.